Andy Xie: Central Banks, Arsonists and Playing with Fire

Money supply growth has sparked an asset market boom that supports the economy, not the other way around. Don't get burned.

By Andy Xie, guest economist
to Caijing and a board member of Rosetta Stone Advisors Ltd.

(Caijing Magazine) Is money
demand efficient? The answer could help decide what's best for monetary policy.
Moreover, as financial institutions have demanded more money to support their
leverage, money demand efficiency has become equivalent to financial system
efficiency.

I think the answer is no. Monetary
authorities and central banks have a responsibility to take this reality into
account. Their best approach would be to limit the deviation of monetary growth
from nominal GDP growth. In particular, sustained deviation should be corrected
-- even if the underlying economy suffers in the short term.

This is a serious academic topic
these days. Some of the world's most prominent economists hold different views.
Why discuss it here? First, it's important to everyone. After all, retail
investors dominate China's asset markets, and most base their investments or
speculation decisions on expectations that the government will not let asset
prices fall. The credibility of this expectation depends on whether money
available for government spending is limited. A discussion on monetary
expansion's limits can help Chinese investors assess the risks of their
investment decisions.

Second, money supplies worldwide
are rising much faster than nominal GDP growth rates. That is, monetary growth
is being used to support leverage, mostly in the financial sector. Of course,
the reason is central banks have responded to the financial crisis by cutting
interest rates and sometimes force-feeding banks with liquidity in hopes more
lending will boost the economy. But instead, money has flowed into and led to
buoyancy in asset markets (stocks and bonds in developed economies, and almost
everything in emerging economies).

Buoyant asset prices have
stabilized the global economy. Most analysts say buoyant asset markets reflect
correct expectations of a buoyant global economy. I don't think this is true. As
we saw in the past decade, the latest asset market boom is supporting the
economy, not the other way around. In other words, it's a bubble.

Even though the global economy is
staging a modest recovery, mainly on inventory restocking and fiscal stimuli,
the overall economic situation is still difficult. Unemployment rates in OECD
countries are at record highs. Global trade is still at one-fifth its peak
level. The small- and medium-sized economies that employ most of the world's
people are struggling. We see a contrast – unprecedented in modern times --
between the asset market boom and real economic difficulties.

The gap is creating social tension
around the world. While workers and businesses struggle, asset players are
reaping substantial paper profits again. As the central bank's monetary policy
is behind the asset boom, we should ask whether the policy is achieving its goal
by helping the real economy, or whether it is just helping speculators and
hoping they have something left over for the real economy.

The financial crisis exposed gross
inefficiencies in the massive amounts of money financial institutions received
from central banks. Supplying so much money to the same people who caused the
crisis -- and with the same incentives -- does not feel right. The argument in
favor of this policy is that, when the house is on fire, you have to do whatever
to extinguish the fire and find the culprit later. The problem is that, in this
case, the arsonists have been asked to put out the fire. How can we be sure they
won't start another fire?

Most argue that the answer is not
to limit the money supply but to reform the financial system. In this way,
future demand for money would be efficient. But so far, no corrective reforms
have been implemented in response to the financial crisis. Why? Because the
global financial system became so big over the past decade that it has co-opted
central banks, legislators and entire governments. Any reforms that do come will
not address the main factors leading to the current crisis.

Even the best reforms will never
resolve a problem based on the fact that financial professionals generally risk
other people's money: They get big rewards when bets go right and don't have to
pay when bets go wrong. The problem with this incentive system suggests the
global financial system is structurally biased toward taking on more risk than
what would be taken in an efficient market.

The only way to counter this is
for central banks to limit money supplies. Asset inflation over the past 10
years and the catastrophe incurred when it burst lend credibility to this
argument.

Stagflation in the 1970s spurred
economists to study why monetary stimulus, over time, loses its punch. Demand is
stimulated, but that leads to inflation. And it's led to development of the
rational expectation theory to explain the average Joe's response to monetary
policy. Its conclusion, although obvious to the uneducated, is that policymakers
cannot fool people again and again. For that observation, many have won Nobel
prizes. Milton Friedman advocated money supply growth targets as a guiding
principle for central banking. Such an approach would put central banking on
autopilot with a target of money growth and leave the market to decide interest
rates.

The rational expectation theory
was extended further to explain investor behavior. This led to the efficient
market theory, which posits that, under some conditions, rational investors will
lead to efficient asset prices that correctly anticipate the future. Academic
jargon for efficient asset price says that it includes all useful information
about the future. That laid the foundation for tearing down the regulatory
structure built from the lessons of the Great Depression.

Stagflation of the 1970s led to
central banking to focus narrowly on short-term inflation. The efficient market
theory prompted central banks to completely accommodate financial institutions
that demanded money for leverage funding. This combination of policy steps laid
the foundation for the big bubble in the past decade. As globalization kept
inflation low, Wall Street could source an unlimited amount of liquidity from
central banks for bubble making.

Even though globalization has
maxed out, and the global economy has now entered an inflation age, the bursting
of the last bubble is a negative demand shock that's keeping inflation low for
the time being. This has created another window for bubble-making. A last-train
psychology means this bubble is growing quickly, totally oblivious of economic
fundamentals. In addition to the usual misinformation from market makers who
want to sucker people, government officials, financial professionals and the
media are also saying what speculators want to hear. This is yet another episode
of an inefficient market adventure.

Institutional investors dominate
financial markets in western countries, while retail or individual investors are
the main players in the east. Neither group is thinking or behaving rationally.
Most institutional investors are benchmarked against market indexes quarterly,
and with cash-holding limits. These constraints obviously have disadvantaged
them and made it extremely hard to outperform the indexes. This is why most
institutional investors are closet indexers. Extra management costs guarantee
that most institutional investors under-perform market indexes and don't add to
market efficiency.

Absolute performance funds or hedge funds are
the biggest development in financial market in the past 10 years. But they have
been amplifying market volatility rather than improving efficiency. The hedge
fund industry has made managers rich, not investors, because managers are
remunerated with a cut on the upside, and don't pay up for the downside. So they
are structurally incentivized to long volatility while playing something like
the coin-flip game "heads I win, tails you lose."

Regardless how one tries to
improve the incentive structure for institutional investors, nothing could
overcome the incentive distortions tied to the practice of managing other
people's money. Institutionalization, once hailed as a great step forward in
improving market efficiency, has proven to diminish efficiency. Developing
countries that face highly volatile markets have been looking to
institutionalization as a way to calm them. They should think twice.
Institutionalization may decrease short-term volatility but make up for this
advantage with a big crash.

Retail or individual investors
routinely mistake volatility for trend. Their herd behavior creates
self-fulfilling trends that are mainly temporary. From time to time, such herd
behavior lasts a long time and leads to big bubbles, which in turn lead to major
misallocations of resources.

To minimize chances of future
financial crises, one could reform the financial system to make it less
crisis-prone, or target both asset and CPI inflation when setting monetary
policy. When the crisis began a year ago, policymakers around the world swore to
reform the system while ridding it of corruption and excess leverage. After
governments bailed out financial institutions with trillions of dollars, the
impetus for reform waned. Reform bills in the U.S. Congress have been watered
down so much that they would not prevent another major
crisis.

Capital requirements and transparency are key elements to
address in any effective financial reform. And unless reforms target problems in
the derivatives market, they will not be effective. Over-the-counter derivatives
carry hundreds of trillions of dollars in notional value, thriving in an opaque
environment. Derivatives in theory help buyers decrease risk, but in practice
they are merely tools for taking on more risk, hiding leverage through complex
structuring. Market-makers can earn high profits by fooling buyers and
regulators, overcharging while putting up little capital to warehouse such
high-risk products. If the market is made transparent and capital requirements
are reasonable, this business would shrink.

Every party ends sooner or later,
and I see two scenarios for the next bust. First, every trader is borrowing
dollars to buy something else. Most traders on Wall Street are Americans,
British or Australians. They know the United States well. The Fed is keeping
interest rates at zero, and the U.S. government is supporting a weak dollar to
boost U.S. exports. You don't need to be a genius to know that the U.S.
government is helping you borrow dollars for speculating in something
else.

But these traders don't know much
about other countries, particularly emerging economies. They go there once or
twice a year, chaperoned by U.S. investment banks eager to sell something. They
want to think everything other than the U.S. dollar will appreciate; Wall Street
banks tell them so. Since there are so many of these traders, their predictions
are self-fulfilling in the short-term. For example, since the Australian dollar
has appreciated by 35 percent from the bottom, they now feel very smart while
sitting on massive paper profits.

When a trade like this one becomes
too crowded, a small shock is enough to trigger a hurricane. There must be
massive leverage in many positions, but one just never knows where. When
something happens, all these traders will run like mad for the exit, and that
could lead to another crisis.

Surging oil prices could be another
party crasher. This could trigger a surge in inflation expectation and crash the
bond market. The resulting high bond yields might force central banks to raise
interest rates to cool inflation fear. Another major downturn in asset prices
would reignite fear over the balance sheets of major global financial
institutions, resulting in more chaos.

Twice in recent years, oil prices
surged into triple-digit territory, wreaking havoc on financial markets and the
global economy. In 2006, surging oil prices toppled the U.S. property market,
debunking the story that property prices never fall -- a premise upon which
subprime lending was based. Oil prices fell sharply amid the subprime crisis
period while the market feared collapse in demand. The Fed came to the rescue
and, in summer 2007, began cutting interest rates aggressively in the name of
combating the recessionary impact of the subprime crisis. Oil prices surged
afterward on optimism that the Fed would rescue the economy and oil demand. It
worked to offset the Fed's stimulus, accelerated the economic decline, and
pulled the rug out from under the derivatives bubble. The ensuing fear of
falling demand again caused oil prices to collapse.

Oil is a perfect ingredient for a
bubble: Oil supplies cannot respond to a price surge quickly. It takes a long
time to expand production capacity, and oil demand cannot decrease quickly due
to lifestyle stickiness and production modes. Low-price sensitivities on both
demand and supply sides make it an ideal product for bubble-making. When
liquidity is cheap and easily obtained, oil speculators can pop up
anywhere.

Oil speculators are no longer
restricted to secretive hedge funds. Average Joes can buy exchange traded funds
(ETFs) that let them own oil or anything else. Why not? Central banks have made
clear their intentions to keep money supplies as high as possible, debasing the
value of paper money to help debtors. It seems no good deed is unpunished in
this world. If you speculate big, governments will offer a bailout when your
bets go wrong and cut interest rates and guarantee your debts, allowing bigger
bets. People who live within their means and save some for a rainy day see
dreams shattered. Central banks can't wait to break their nest eggs.

It is better to be a speculator in
this world. The powers that be are with you. Maybe everyone should be a hedge
fund; ETFs give you this opportunity. As the masses are incentivized to avoid
paper money while buying hard assets, the price of oil could surge to
triple-digit territory again. Oil bubbles are easy to come and quick to go
because the oxygen needed for its existence disappears after it kills other
bubbles.

A word of caution for all would-be
speculators: You'll want to run for your life as soon as the bond market takes a
big fall. And the case for a double dip in 2010 is already strong. Inventory
restocking and fiscal stimuli are behind the current economic recovery, and when
these run out of steam next year, the odds are quite low that western consumers
will take over. High unemployment rates will keep incomes too weak to support
spending. And consumers are unlikely to borrow and spend again.

Many analysts argue that, as long
as unemployment rates are high, more stimuli should be applied. As I have argued
before, a supply-demand mismatch rather than demand weakness per se is the main
reason for high unemployment. More stimuli would only trigger inflation and
financial instability.

Stagflation in the 1970s
discredited a generation of central bankers. They thought they could trade a bit
more inflation for a lot more economic growth. Today's crisis will discredit a
generation of central bankers who ignore asset inflation by sometimes trading
asset inflation for a bit of economic growth. Those who play with fire often get
burned, even when the arsonists don't.

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